Daqo New Energy Corp. ($DQ)

"The Sparkling Gem Among the Solar Industry Trash."

and

Kyler Johnson

Aug 09, 2024

This write up was done in collaboration with Kyler Johnson from Value Investing Blueprint .

100% of the research was done by Kyler Johnson, I just added couple of final touches.

If you would like to learn more about Kyler Johnson, check out his Twitter / X & his Substack.

Disclaimer is at the end.

The solar industry is like a minefield, with many absolutely terrible companies destroying shareholder value. But if you dig deeper, you might uncover Daqo New Energy—a company that might initially seem like just another name in the solar sector, but is far from ordinary. This article offers a deep dive into Daqo New Energy’s business and investment potential. Stick around to discover why this extraordinary company presents an exciting opportunity!

If this is the type of reading you like, consider subscribing below to get these articles directly in your inbox each time I send them. It is these articles and analysis that has allowed me to outperform the markets by a wide margin this year.

Understanding the Company

Daqo New Energy supplies polysilicon and polysilicon products for solar panels globally. They produce high-purity polysilicon through a chemical vapor deposition process which involves the reaction of purified silicon tetrachloride with hydrogen.

High purity polysilicon is the foundational material for manufacturing photovoltaic (PV) cells, which convert sunlight into electricity. The purity of the polysilicon significantly impacts the efficiency and performance of solar panels. Higher purity polysilicon allows for the creation of more efficient and reliable solar cells, enhancing overall energy conversion.

The US-listed stock ( DQ 0.00%↑ ) represents a 72.7% ownership of the company.

Understanding the Industry

This is a commodity-type industry where products are primarily differentiated by price. With over 90% of the world's polysilicon supply coming from China, the market is highly competitive.

Such a competitive environment is prone to boom and bust cycles, leading to significant profit fluctuations. The first chart below illustrates three complete boom and bust cycles from 1977 to 2017, while the second chart picks up from there, showing the latest boom in 2022 and the current bust with exceptionally low prices, especially in China.

Due to the industry's fluctuating commodity prices, new entrants often join the market during price increases, causing oversupply. Conversely, as prices fall, high-cost producers exit the market, frequently going bankrupt. This is exactly the situation unfolding now. Daqo's management stated in their most recent earnings report that they expect competitors to start going bankrupt by the end of 2024.

Despite this, the average of 5 industry forecasts suggest demand will grow by about 12.8% per year globally.

In summary, supply will decrease as high-cost producers go bankrupt, while demand will continue to rise. Although the timing of these changes is uncertain, I expect another boom peak within about the next 7 years.

Financial Fundamentals

Margin’s

Since the end of 2009, on a TTM basis, Daqo has maintained a median FCF margin of 7.8%, while their competitors averaged a median FCF margin of -6.84%, with none achieving positive margins.¹

Returns

Since the end of 2009, on a TTM basis, Daqo has achieved a median ROIC of 11.3%, whereas their competitors averaged a median ROIC of 3.91%, with the highest competitor reaching a median of 7.1%.

Leverage

As of 3/31/24 Daqo has net debt of -$2.7 Billion.

Management’s Integrity

Shares Outstanding

Since 2008, Daqo's outstanding share count has decreased by an average of just under 2% per year. Additionally, the company recently announced a $100 million buyback program, representing about 9% of its market cap.

Incentives

Management, from what I could gather, does not have a specific incentives program tied to any particular financial metrics for their bonuses.

Performance

Daqo's management has excelled at creating industry-leading low costs and efficient use of capital. While this success can be attributed to the quality of the management team, the company’s operations are now set up efficiently. Therefore, even if current management were to leave, it would likely require actively poor management to dismantle their low-cost competitive advantage.

Candor

In all the earnings calls I’ve listened to, management has consistently provided a fair and accurate view of the industry, openly addressing real issues like the exceptionally low price environments that could significantly impact their performance.

Company Concerns or Issues

There are no issues with the company's actual operations that I can find. The decline in their stock price is primarily due to a sharp drop in polysilicon prices, which have plummeted around 80% from their peak. This has raised concerns that prices may continue to fall, potentially severely impacting the company’s profitability.

Addressing the Concerns or Issues

Low polysilicon prices will undoubtedly impact Daqo, but as one of the lowest-cost producers in China with a substantial cash reserve, they are well-positioned to endure the downturn longer than their competitors.

How long will this take? While I can’t pinpoint the exact duration, historical peaks and troughs in polysilicon prices have averaged around 13.5 years. This cycle seems to be progressing at a slightly faster pace, potentially shortening the cycle to 8-10 years. With approximately 2 years passed since the last peak, we might expect another 6-8 years before the next boom.

My Thoughts

Examining Daqo’s operations reveals a high-quality company with industry-leading margins and returns on capital. They exhibit the potential for a low-cost economic moat, although I’m cautious about confirming this due to the rapidly evolving nature of the industry. Adding to the appeal, the company is trading at just 2x trailing twelve-month free cash flow and approximately 50% of its net cash balance, making it incredibly undervalued.

However, it’s likely that we haven’t yet seen the bottom for polysilicon prices, and it will be several years, at best, before we see another peak.

My main concern is that I may be too early in my investment, but it was hard to overlook a company that is both this cheap and of such high quality in its industry.

Valuation

Valuing Daqo involves some degree of imprecision, as predicting the height of the next boom is challenging. For simplicity, I’ll assume that prices will reach the same level as the most recent peak, which would result in Daqo’s revenue being about 50% higher than during the 2022 peak. This assumption is based on their 50% increase in production capacity in 2023 and additional expansion plans. To remain conservative, I’ll stick with the 50% increase estimate.

With that assumption, their revenue would be as follows:

Revenue: $6.9 Billion

During the peak revenue period, they achieved a free cash flow (FCF) margin of 53.4%. In this scenario, I’ll use a conservative estimate of a 50% FCF margin, given their continued optimization since 2022. This results in the following FCF:

Free Cash Flow: $3.45 Billion

At their peak, Daqo was valued at approximately 3.1x their peak free cash flow. Assuming similar conditions in the coming year, this would translate to the following share price and market capitalization:

Share Price: $162.70

Market Cap: $10.7 Billion

These numbers suggest a potential return of about 850% from a $17 share price, which is impressive even if it takes 8 years, translating to over a 30% CAGR. This estimate doesn’t account for potential share repurchases or further production expansion, so the outcome could be even more favorable. However, there is also the risk of potential drawbacks if the company issues shares, reduces production, experiences lower margins, or if polysilicon prices don’t reach similar peak levels.

The key assumptions for this scenario to materialize are:

Polysilicon prices follow a similar boom and bust pattern as the last 4 cycles.
Daqo survives the low price environment solely by leveraging its cash reserves.
Daqo maintains operational efficiency comparable to the 2022 boom.
Demand for polysilicon remains steady or increases in the future.

These are significant assumptions, but they seem reasonable given that the industry has experienced 4 similar cycles over the past 50 years, and there is increasing global emphasis on solar energy for renewable power.

Holdings Disclosure

Daqo DQ 0.00%↑ is currently a smaller position in Kyler’s portfolio, and it will require considerable patience to realize the potential rewards. However, Kyler believes the investment will be well worth it in the end.

While I (YZ) will not be considering or starting position because it does not match my main criteria for a core position in my portfolio.

P.S. Don’t forget to ❤️ if you enjoyed it.

Disclaimer from Kyler: This content is for informational and entertainment purposes only. The opinions expressed here are my own and not professional financial advice. I do not know your personal financial situation. Before making any investment decisions, you should do your own research and consult with a licensed financial advisor. Investing involves risk, including the potential loss of principal.

Disclaimer

The information in this article is provided for informational and educational purposes only.

The information is not intended to be and does not constitute financial advice or any other advice, is general in nature, and is not specific to you. Before using this article’s information to make an investment decision, you should seek the advice of a qualified and registered securities professional and undertake your own due diligence.

None of the information in this article is intended as investment advice, as an offer or solicitation of an offer to buy or sell, or as a recommendation, endorsement, or sponsorship of any security, company, or fund. The author is not responsible for any investment decision made by you. You are responsible for your own investment research and investment decisions.

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